Discussion Paper Details

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Title: Sources of entropy in representative agent models

Author(s): David Backus, Mikhail Chernov and Stanley E. Zin

Publication Date: July 2011

Keyword(s): asset returns, bond yields, disasters, habits, jumps, pricing kernel and recursive preferences

Programme Area(s): Financial Economics

Abstract: We propose two metrics for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The metrics describe the pricing kernel?s dispersion (the entropy of the title) and dynamics (time dependence, a measure of how entropy varies over different time horizons). We show how each model generates entropy and time dependence and compare their magnitudes to estimates derived from asset returns. This exercise--and transparent loglinear approximations--clarifies the mechanisms underlying these models. It also reveals, in some cases, tension between entropy, which should be large enough to account for observed excess returns, and time dependence, which should be small enough to account for mean yield spreads.

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Bibliographic Reference

Backus, D, Chernov, M and Zin, S. 2011. 'Sources of entropy in representative agent models'. London, Centre for Economic Policy Research.